This article first appeared in The Edge Malaysia Weekly on November 12, 2018 - November 18, 2018

SOME 10 years on from the 2007/08 global financial crisis, banking industry revenues are growing at well below their historical average.

A study by McKinsey shows that while the global banking industry has improved steadily in terms of level of safety since the crisis — Tier-1 capital ratio, for example, one measure of safety, has moved up to 13.2% last year from 9.8% in 2007 — growth, however, has been dull.

“Growth for the banking industry continues to be muted. Industry revenues grew at 2% per year over the last five years, significantly below its historical annual growth of 5% to 6%,” says Miklos Dietz, a senior partner at the consulting firm, in its latest annual review of the global banking industry, released on Nov 7. Dietz co-wrote the report with five others.

McKinsey describes the industry as being “safer, but stuck in neutral”.

Growth in investment banking in particular has been anaemic in the last five years. Last year, revenues fell to US$275 billion compared with US$345 billion in 2007. Revenues expanded at a compound annual growth rate (CAGR) of just 0.4% from 2012 to 2017.

This is not entirely surprising. Recall that several major investment banks, including Credit Suisse, UBS and Deutsche Bank, had over that period recalibrated their strategies, pulling back from certain markets and cutting thousands of jobs amid a tougher operating environment that included tighter capital requirements.

Interestingly, wealth and asset managers have outpaced other banking segments, growing revenues at a CAGR of 5% over the 2012 to 2017 period, compared with a CAGR of 3% over 2007 to 2012. Their revenues improved to US$660 billion last year compared with US$465 billion in 2007.

These were some of the key findings in the McKinsey report titled “New rules for an old game: Banks in the changing world of financial intermediation”, which is based on data and insights from its proprietary banking research arm, Panorama, as well as clients’ experience.

Local banking analysts tell The Edge that the trends are generally similar in the Malaysian banking system. Annual growth in operating income and operating profit, for example, have dropped to a single-digit pace since 2011.

“You will find similar trends in Malaysia, and the main reason is that it is harder for banks to do business — partly because of the overall economic environment and partly because the cost of doing business has gone up, given that compliance costs have risen as a result of stronger regulation. Hence, you have margins coming down,” one analyst says.

The McKinsey report notes that globally, the average banking return on equity (ROE) after tax has hovered in a narrow range of between 8% and 9% since 2012. This consistent performance is “impressive” considering the increases in capital ratio requirements during the period, Dietz says.

Compared with other industries, the ROE of the banking sector falls in squarely in the middle of the pack. But, when it comes to valuations, they are consistently lower.

“If we look at banking from an investor’s point of view, we experience a jarring displacement: the banking sector’s price-to-book ratio was consistently lower than that of every other major sector over the 2012 to 2017 period — trailing even relatively sluggish industries such as utilities, energy and materials,” Dietz notes. The price-to-book ratio for banks was at a sharp 45% discount to non-banks last year.

Similarly, the price-earnings ratios for the banking industry have consistently traded at a steep discount to other major industries — 39% in 2017 compared with near equality in 2008.

Why are investors cautious about banking prospects? Dietz offers this explanation: “In part, low valuation multiples for the banking industry stem from investor concerns about banks’ ability to break out of the fixed orbit of stable but unexciting performance. Lack of growth, and an increase in non-performing loans in some markets, may also be dampening expectations.

“Our view, however, is that the lack of investor faith in the future of banking is tied in part to doubts about whether banks can maintain their historical leadership of the financial intermediation system.”

He points out that these concerns have come about as the industry faces competition from other financial services firms, non-bank attackers and technology companies.

McKinsey believes that the changes coming to the global financial intermediation system will be profound. “However, they do not assume that banks will become irrelevant. For instance, there will always be demand for risk intermediation. The question is whether banks will be disintermediated, disaggregated, commoditised or whether banks can maintain and expand their role in intermediation,” says Rushabh Kapashi, a McKinsey partner and one of the co-authors of the report.

Interestingly, last year, the price-to-book ratio of developed market banks overtook that of emerging markets for the first time in many years. “This is the culmination of a decade-long trend, and reflects the increasing risk cost of non-performing loans in emerging markets, investor uncertainty in China and competitive moves from digital firms that have thus far been bolder in emerging markets than in developed ones,” Dietz says.

He notes that the gap in banking ROE in developed and emerging markets is also closing. “While the average ROE in emerging markets is still significantly higher than that of developed markets, the gap has been closing and, last year, it reached its lowest level since 2002.”

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